Sunday, November 22, 2009

Financial Markets Review : Dovish MPC Minutes Adds to the Pressure on UK Yields

Financial market review - foreign exchange The pound has recorded a split performance this week. It fell against the low yielding currencies (Japanese yen, US dollar, euro and Swiss franc) and rose against the commodity currencies (Canadian, Australian and New Zealand dollars) and the Swedish krona.

GBP/USD closed the week at $1.6519, pulling back from the 3-month high ($1.6878) recorded on Monday, but remains firmly within its 5-month trading range of $1.57- $1.7050. GBP/USD rallied during the early part of the week, supported by the slightly stronger inflation report, which showed consumer price inflation picking up to 1.5% in October (this marks a medium term turning point in the index). Sterling was under pressure in the second half of the week as the public finances report showed the UK government had borrowed £11.4bn in October (in a month that usually generates a surplus for the government). The retail sales report, which indicated sales up 3.4% y/y, was insufficient to offset the negative impact on sterling from the public finances report.

The USD performed well this week – in the G-10 currency space it lost out only to the Japanese yen. A stronger than expected inflation report and below consensus housing data (building permits and housing starts) helped trigger a rally in the US dollar. Over the week, other economic data were also softer than expected. Industrial production, capacity utilisation, NAHB housing market index and US leading indicators all provided a downside surprise. This left the S&P500 unable to sustain its rally above 1,100 and ends the week at 1,087. Falling equity markets are an environment in which the USD has excelled over the past year. This week has been no different, with the USD index rallying 1.4% off the 2009 low (recorded on Monday) to close at 75.6.

The New Zealand dollar tumbled after a government discussion paper suggested that currency strength was hurting competitiveness. In the paper, it was argued that the Reserve Bank of New Zealand should keep interest rates low to help weaken the currency. The RBNZ has already issued its own concerns regarding the NZD, warning that investors should note that New Zealand is different from Australia in the commodities that it exports (lacking minerals) and not benefiting as much from the growth in China. Hence, suggesting that AUD/NZD should be higher.

New Zealand is not isolated (across developed market nations) in its concern about the strength of its currency. European officials have often mentioned the euro, which is less than 2% off its all-time high (on a trade weighted basis). This week the Bank of Canada also discussed the level of the Canadian dollar. Governor Carney stated that persistent CAD strength will more than offset the domestic economic improvements observed since July. Rising vocal concerns about currency strength suggests this will become an important issue at G-20 meetings over the coming year.

In the emerging market space, the USD outperformed against most currencies. The South African rand was particularly weak falling 2.3% against the USD, to close at 7.58. Equity market outflows and discussions by politicians and the central bank that the level of USD/ZAR was harming the economy, weighed on the rand.

Interest rate market review - bonds, cash and swaps

Government bonds rallied this week as risk-taking scaled back on the approach to year-end. A dovish set of MPC minutes combined with a slowdown in US leading indicators drove yields lower throughout the week. A rush into cash, possibly due to “window dressing” for year-end by financial institutions, sent short-term US rates into negative territory for the first time since the aftermath of the Lehman bankruptcy. US 2yr swap rates fell to a new record low of 0.98%. UK swaps and gilts outperformed bunds and Treasuries following the minutes of the MPC meeting. In the UK, dovish MPC minutes sent 5yr gilt yields down to 2.61%. UK 3-month libor fell a touch to 0.61% leading to a flatter curve by the end of the week.

Bond yields and swaps moved steadily downwards for most of the week with many maturities now trading towards the bottom of recent ranges. Despite an unexpected three-way split vote revealed in the latest set of MPC minutes, the content was fairly dovish with one MPC member (David Miles) voting for an extra £40bn worth of QE. The sharp rally in short-sterling and the move lower in swap yields, particularly at the short-end, was driven by comments from the MPC that a cut in the rate payable on commercial bank reserves was discussed and could still be a good option in the future if necessary. The 2s10s swap curve steepened following the release out to 208bps. The outperformance of gilts versus bunds and Treasuries highlights the fact that the UK appears to be at the back of the queue when it comes to QE exit strategies. The quarterly US Treasury refunding is scheduled for next week and could keep longer-term yields under upward pressure. The Treasury announced a total of $118bn of Note issuance comprised of 2yr ($44bn), 5yr ($42bn) and 7yr ($32bn) Notes.

Apart from the MPC minutes, there were a number of other key data releases this week. One of the themes of the week was inflation. In the UK, CPI rose to 1.5% in October, the first year-on-year rise in the rate since February and likely marking September as the trough in the inflation cycle. With upward base effects from energy prices and the VAT hike to come through, CPI could possibly be back over 2% by the year-end. Retail sales came in stronger-than-expected at 0.4% in October with upward revisions to the previous month. The positive outcome, however, was not enough to overshadow the move in rates generated the previous day following the MPC minutes. An improvement in mortgage approvals and the M4 money supply data also failed to support yields over the week. 10yr gilt yields closed the week down at 3.64% (-15bp) while the curve ended flatter at 239bp.

US Treasuries also performed well this week, supported by some weaker economic data. Housing starts fell unexpectedly to 529k from 592k, raising concerns that the housing market recovery in the US may well be even more drawn out than expected. Industrial production also came in below consensus at 0.1% (expectation at 0.4%) providing further support to bonds while PPI also surprised to the downside. Retail sales, however, registered a robust 1.4% increase in October with the core rate (excluding autos and gas) up 0.3%. Following the housing starts release on Wednesday, 2yr Treasury yields fell to a new record low touching 0.75% intraday. A slightly stronger CPI outturn (0.3%) and a strong Philadelphia Fed survey failed to stem the decline in yields which was exacerbated by comments from Fed member Bullard who noted that in previous recessions, rate hikes in the US did not start until 18 months after the unemployment rate peaked. The US swap curve bull steepened over the week with the 3yr swap outperforming, ending the week down 14bps at 1.59%. The 2y/10yr swap curve steepened from a low 235bp earlier in the week to 245bp.

Eurozone 10y bunds underperformed gilts but outperformed Treasuries, with yields falling 12bps to 3.25%, the lower end of the two-month range. France found good demand for notes this week with both conventional and inflation-linked paper attracting decent bid/cover ratios. EU-16 CPI was in line with expectations at -0.1% y/y. 5y swaps closed the week down 6bps at 2.72%.

Full Report in PDF
Lloyds TSB Bank
Disclaimer: Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.

No comments: